Not many of my posts generate a large number of quality responses.? Rather than respond in the comments area, I thought I would make this a separate post.? My views on the Fed are eclectic, and a little quirky, because I am a skeptic about the power of central banking generally, on both the upside and the downside.? I’ve done fairly well as a bond manager using my views of the Fed to add some value.? (I’m not a bond manager now, though I would like to run a bond fund again at some point.)
First let’s clear the decks.? I am not short.? I am not underinvested in stocks, or private equity.? I am also a “lone wolf.”? I don’t work for anyone.? When I worked for my prior employer, what I posted here and at RealMoney often disagreed with the view of the owner/founder (a genuinely good fellow, and a bright guy).? What I said, I said on two levels.? First, what should be: maintain a tight-ish monetary? policy, because the crisis is nothing the the Fed should be concerned about.? I care about public policy.? I don’t like inflation, which is very understated by the PCE, and understated by the CPI, for reasons that I have stated previously.? I also don’t agree with the concept of core inflation.? If you want to remove volatility, trim the mean, or use a median.? But excluding whole classes of goods is bogus, particularly when their removal lowers the CPI by a lot.
My view is that the temporary injections of liquidity will fail.? There will be enough demand for additional short term liquidity that the Fed will have to begin making permanent injections of liquidity into the system, and eventually cut the Fed funds rate.? Once you cross the intellectual barrier of providing enough incremental liquidity to keep the system afloat, you have committed to an uncertain course of action that will likely lead to rate cuts eventually.? If the goal of monetary policy shifts, so will the direction of policy, usually.
Has the Fed lost control of monetary policy?? Yes and no.? Yes, if they continue to do business the way they do now.? No, if they want to get ugly, and restrict the ways the banks do business, either through regulation or through a modification of the risk-based capital rules.? Even so, what can they do about stimulus via foreign purchases of US debts?? Not much, and even the US Treasury would have a hard time there.
Why have the markets been so good for 25 years? I have five reasons:
- Demographics — the Baby Boomers entered their most productive years.
- Easy Federal Reserve — after the overshoot of policy in the early 80s, the Fed was far more activist and willing (particularly under Greenspan) to throw liquidity at problems that should be liquidated by the free markets.
- Capitalism — Almost every nation is Capitalist now, even if it is crony Capitalism.
- Deregulation — business benefited from deregulation under Reagan (and no one else).
- Free-ish Trade — Trade isn’t really free, but many nations are more willing to compete globally, and the deflationary effects of that competition have been a real benefit.
Finally, I am still thinking about what will benefit from a shift in Fed policy.? I mentioned high quality financials.? To me, that means companies like Hartford (or maybe PRU), which I don’t own at present.? Maybe Wells Fargo?? I’m not sure, but it would have to be institutions that have suffered a real price setback, where a permanent impairment of capital is unlikely.? But what other industries will benefit from lower financing rates?? That is the $64 billion question, and with that, I bid you good night.
Hello Mr. Merkel. I recently stumbled across your blog page, and have found it an extraordinary learning tool. Thank you very much for taking your time to post here regularly. I also wanted to say that your previous two posts on monetary policy were terrific, as were the replies.
Having said this, I have a question for you. If you don’t have time to reply, no worries, as I completely understand that you are a VERY busy guy.
– How did you go about increasing your understanding of economics and financial markets? Are there books, Fed speeches, and/or other “learning tools” that you’d recommend I read/engage in?
Again, thank you very much for keeping this blog.
Best Regards,
Matthew
Thanks for the follow-up David.
If you don’t mind me gushing ever so slightly I think what makes your blog such a refreshing change is that it is written by a regular guy with a tremendous amount of experience who is a moderate bull and with out an axe to grind or an agenda to push. It has an authenticity that I think many people can warm-up to. There are plenty of sites for folks that want their biases reinforced, and sites for folks that want the latest hot tip, and sites for folks that want the most logically rigorous jeremiad, But there isn’t, so far as I know, a site carefully written by a regular guy with your tremendous amount of experience humbly playing it with all his cards on the table. So for that, thanks.
Now, if folks will bear with me going on a bit longer, I’d like to add something to the current discussion. I too have been of the mind this is a 1998 redux. I remember all too vividly taking a beating on a bunch of shorts for over 6 months (this after only being an active investor for only about 2 years) when in August things changed and it felt like I was printing money. I couldn’t believe the difference. (As an aside I’ve compared the home-builders and lenders as the easiest short money since the Y2K remediators way back then.) This summer has been similar, in late April I bought a bunch of deep-ITM, fall puts (in retrospect I was lucky shares couldn’t be borrowed) on the usual suspects in Alt-A. May and June I just kept telling myself, be patient… takes time… it’s just like Y2K. Now for the last 4 weeks it has felt like I’ve been printing money. Actually I’ve left a bunch on the table as I booked profits too soon. But I remind myself pigs get slaughtered, and be happy with my good fortune that has vastly exceeded anything I thought I’d be making when I made these investments back in April. In 1998 I remember all too well when the fed cut rates and the stock market went on a tear and all my gains went poof as fast as they’d come in. So, being ~10 years older, 10 years wiser, 5 times richer, and having 5 times the dependents (if you hadn’t guessed I was 25 in 1998 ;-), I’m staying ready in case of a Fed cut and market turn.
BUT, here’s the thing that bothers me (and I suspect many others as well) while you’ve stated the quantitative case about how spreads are so much better and yields so much lower than ’87, might the qualitative difference that this is a mortgage and *housing* crunch mean it’s different this time?
I hate to bring-up ’29 but to my way of thinking the balloon mortgages that made for the Great Depression’s unrelenting turmoil have their modern counterpart in the Option-ARM and the various teaser IO’s with their 2 year reset. My history is not what it should be, but isn’t the mortgage crunch during the Depression get the blame for its unrelenting nature? It sure seems to me if things go south from here people 50 years hence and forever more will be saying, “Sheesh, what were they thinking? The hand-writing was on the wall!”
Here’s another thing that strikes me as different between now and ’98. In ’98 we had the Russian crisis and the LTCM implosion. The primary effects of those were limited and mostly hit professionals that were psychologically able to take a hair-cut. The fear was all in the potential secondary effects. Well today, we’ve seen a number of hedge funds blow up. I think if one sums them all up they may exceed LTCM (or no?). But hey it’s still pros who can take a hair-cut. But the housing crunch is Main Street stuff and there was no Main Street analog in ’98.
Admittedly my argument is all qualitative conjecture. David, what I’ve always appreciated from your writing is the quantitative rigor you provide. So if there is something quantitative that you think mitigates the impact a housing crunch could make please share. Or anyone for that matter. I want to be a bull. One thing I remember from Cramer is that the bears will always make all the best arguments, but they won’t make money. 😉
Thanks for the length indulgence if you’ve made it this far. All my best,
-Allan
Hello David,
Thanks for responding to the issue of the Fed’s control over monetary policy. I agree that they could, in theory, take control again. However, history suggests that they will not get the stomach to do so, if ever, until a major crisis develops. I believe that Paul Volcker and President Reagan were extremely courageous for taking the actions (or non actions in Reagan’s case) they did 25+ years ago. However, the country had already been in a major economic AND social funk for a long time. People haven’t felt enough pain in the past few years to warrant such political courage just yet – at least in my opinion.
The Fed’s repo action is normal. But I hear that they conducted repos on MBS, albeit high-quality, at Treasury rates. Is that normal?
Few people reply because few people have the same command of the subject matter as you. As they say, it’s lonely at the top.
Said Mark Twain: Better to be thought a fool than speak up and remove all doubt.